Don’t Put Your Head in the Sand Because of Cash Balance Liability Complexity

In its U.S. Pension Market Quarterly Outlook, Insight Investment looks at what it calls generally the most complex pension liabilities of all—cash balance plans—and how they can be managed in practice.

Kevin McLaughlin, head of liability risk management with Insight Investment in New York City, says this matters because most of the firm’s clients are on the path to de-risking their plans, and, as they get farther down the path, managing assets to liabilities gets more important—unhedged liability risks become a bigger component of residual risk. “If they’ve done all the hard work to get their defined benefit plan funded status to 100%, they want to make sure things are locked down to have more certainty of outcomes,” he says. “They may have ignored these risks in the past.”

McLaughlin adds that many plan sponsors, as they’ve reconstructed their benefit plans and frozen their traditional defined benefit (DB) plans in the last couple of decades have, in a number of cases, introduced a cash balance component. “It is quite common to come across a cash balance benefit in DB plans,” he notes.

The way a cash balance plan works is that a defined contribution (DC) type of payment is contributed to employers to cover their benefit balance, an interest crediting rate—chosen by the plan sponsor—is applied to participant account balances, and, at retirement, participants can typically take a lump-sum distribution or select an alternative annuity benefit. According to the Insight Investment report, this creates “three distinct, but interrelated, uncertainty risks in cash balance plans: lump sum optionality, duration risk (including liquidity), and interest crediting.”

Lump Sum Optionality Risk

McLaughlin explains that plan sponsors do not know with any great certainty which form of payment they will have to pay to participants, and they need to be prepared to deliver either a lump-sum distribution or an annuity. This create a hedging and liquidity challenge in managing the asset, as the duration of a lump-sum payment is zero, while the duration of an annuity can be 10 or 15 years; and the amount of the liability itself can change depending on the form of payment, with one benefit cheaper than the other on a present-value basis.

According to the Insight Investment report, the annuity benefit is more valuable if the interest rate used to calculation the annuity conversion is below prevailing market rates; and conversely, the lump sum is the more valuable option when the annuity conversion rate is higher than prevailing market rates. This can certainly influence a participant’s choice between a lump sum and an annuity. In addition, McLaughlin says there is an extra potential cost factor for the plan sponsor: as faced with a choice of benefit form, participants who think their life expectancy is low may consider taking a lump sum, while those who think they will live a long life will typically take an annuity. Hence, the expected duration of annuities may be longer than for a typical retiree pool.

That said, he notes that in practice from year to year, the typical take-up rate for lump sums versus annuities tends to be pretty steady, though the previously mentioned factors can affect that. Plan sponsors should set up their portfolio to prepare for both types of payments.

What this looks like, McLaughlin says, is a portfolio with a high degree of liquidity to be able to pay someone out quickly if needed. “There is no perfect investment or hedge to meet the lump sums or annuity payment option,” he says. “But we would suggest a combination of cash bonds and a derivative overlay strategy to balance the liquidity and potential duration needs. If it turns out more participants take lump sums than expected, plan sponsors can take away some of the duration hedge.”

Duration Risk

“If the interest rate used to calculate the annuity is somehow indexed to current rates, we believe the risk is much less to the plan sponsor. But even when this is the case (it often isn’t), there can still be problems: 1) plans that have converted to cash balance will often have a legacy defined benefit which serves as a minimum that may not be lowered regardless of changes in rates; and 2) hedging the risk means keeping the duration of the portfolio very short, which may cause portfolio earnings to be inadequate,” the report says.

While there are different ways to set the plan’s crediting rate based on the Employee Retirement Income Security Act (ERISA) safe harbor, McLaughlin says a typical scenario is to use the yield on the 30-year Treasury bond, often combined with a floor of 3% or 4%. The problem is, there is “no investment we can find that will give a return like the yield on the 30-year Treasury bond, so the only way to manage the liability risk is dynamic hedging, which changes as the interest rate changes,” he notes.

McLaughlin explains that if the interest rate is low, the investment goal is clear. Plan sponsors should find an investment strategy that delivers a 4% return—with a profile that looks like the liability. If the interest rate rises, there’s a possibility the crediting rate will be greater than 4%. In that case, plan sponsors should find investments that mirror the possibility of the interest rate on the 30-year bond and implement an appropriate investment and hedging strategy.

“Plan sponsors may jump to the conclusion that they should buy a 30-year Treasury bond, but they don’t get the yield unless they hold it for more than 30 years. It won’t produce the annual return needed, so it is not a good hedge,” McLaughlin adds.

Interest Crediting Risk

The report goes on to note that “if the crediting rate is fixed, the plan may invest to lock in earnings to cover that rate to the extent possible (subject to credit quality constraints). If the rate varies, the asset-liability mismatch risk can be addressed by keeping the investment portfolio’s duration very short.”

But, it says, the most difficult situation is for those plans with crediting rates that are the greater of a fixed rate and an indexed rate. “The plan is effectively short an option, which will be difficult and or expensive to hedge—especially in an environment where the fixed and variable rates are close to each other.”

McLaughlin says there are a range of interest crediting rates in cash balance plans. Other than the most common one previously mentioned, some use the yield on the one-year Treasury rate fixed return, and others link to corporate bonds and Treasury bonds. “Our general advice is simple; the first port of call is to understand the materiality of the risk. In some cases, it may be very small. If so, we would advise plan sponsors to monitor the risk and if it grows, take action. There’s no need to complicate things with the investment strategy,” he says.

“If the risk is much bigger, effectively, plan sponsors would need a more dynamic hedging strategy that reflects the yield on the market or interest rates. An ideal portfolio has a combination of bonds and derivative overlays,” McLaughlin adds.

Collaboration Is Necessary

Dealing with liability complexity in cash balance plans does require a closer collaboration between investment managers and actuaries, McLaughlin says. “What you want from the actuary is projected cash flows—just as you’d want for a final-average-pay DB plan. But, for cash balance plans, you want more information—the expected liquidity profile and also a profile of benefit lump sums versus annuities,” he says. “There should be a discussion around the sensitivity of interest rates and how the liability can change or move if the assumed take-up rate for lump sum or annuity distributions changes. The actuary has this data and knows participant behavior well.”

Regarding interest crediting rate risk, McLaughlin says because there is no single agreed-upon way to solve or hedge the problem, the best way forward is to have a discussion between the actuary and investment manager or in- house chief investment officer (CIO) team to make sure everyone understands the risks and the risk tolerance of the plan sponsor, and to find a solution everyone can understand and monitor over time.

“Some plan sponsors may ignore the liability risks in cash balance plans because of the complexity,” McLaughlin says. “Our advice would be that this is not something you should ignore. Invest the time to understand the risks and create a clear strategy. Reach decisions through information and analysis.”